The Useless Nature of the P/E Ratio
Mental Framework
Edited by Brian Birnbaum.
The P/E ratio ignores the rapidly evolving nature of modern income statements.
When it comes to investing, valuation is the primary concern, along with the evolution of free cash flow per share growth. Over the long term, stock prices track the latter metric. If FCF/share increases at a rate greater than that which was discounted in a given company’s valuation at purchase, you will make money.
For tech companies, an increase in free cash flow per share usually involves a metamorphosis of the income statement. This often renders redundant many metrics used for more traditional and/or mature businesses–such as the price to earnings ratio.
Tech companies tend toward winner-takes-all scenarios in which profits accrue later in the corporate lifespan. This is especially true of businesses with network effects, wherein scale precedes profits in the list of strategic priorities.
In other words, investors must develop a deeper, more nuanced understanding of the income statement to obtain relevant information about the company’s prospects. The more rapid a company’s and/or industry’s evolution, the more context is required to parse the income statement’s signals. Metrics that summarize the income statement for more traditional businesses–e.g. net income, operating income, or PE–tend to exacerbate the distortion of information.
Because the best AI models result from the best data, network effects are the essence of AI. By definition, such data breeds network effects that ultimately eliminate the rest of the competition. As a result, moving forward, more companies than ever will have to prioritize scale over profits to remain competitive; and the futility of the P/E ratio is likely to extend far beyond tech.
The world’s best tech companies tend to heavily reinvest capital. Because most tech spending does not appear as CapEx on the Statement of Cash Flows, instead depicted as an expense on the income statement, the bottom line becomes nearly useless. To maximize shareholder value a company should in theory reinvest the maximum amount of profits that can provide a satisfactory return, strengthen the moat as much as possible, and minimize taxes, a playbook perfected by Jeff Bezos before analysts even understood what he was doing. As previously mentioned, this is especially the case in competitive dynamics driven by network effects.
Amazon focused on compounding scale and customer goodwill over profits. The market misinterpreted this strategy for decades, even as recently as early 2023. Despite the increasing significance of network effects in competitive dynamics, the market is still focused on the income statement as the primary source of fundamental signals.
Because of the market’s myopic focus on the income statement, the trained eye will have located many notable opportunities in the recent past. The most prominent example, after the Meta and Amazon circa 2022-2023, is Spotify. For 17 years revenue-sharing agreements with music labels dictated Spotify’s gross margins, stuck at 25% for the past decade. The market was focused on this fact instead of the readily-evident fact that Spotify was cultivating unstoppable network effects.
On a first principles basis, I understood said network effects stemmed from Spotify’s ability to iterate on the user experience to maximize user satisfaction in a way that competitors couldn’t. Going forward, increased operating leverage would be a function of Spotify repurposing that organizational ability to profitably introduce new audio verticals. This qualitative analysis of Spotify, which I teach in my Tech Stock Goldmine course, assigned high odds of success.
Below you can see how Spotify’s free cash flow in the last twelve months has evolved. The stock is up over 4X since I bet the house on it and, per my understanding of the company, this is just the start.
Due to Spotify’s network effects and tendency to reinvest capital, the cash flow statement is a much better indicator for the evolution of a company’s earning power. Looking at the cash flow statement alone isn’t enough–qualitative analysis is the foundation upon which any investment thesis is built–but it would have revealed that, contrary to popular belief, Spotify was solvent.
The elusive nature of a tech company’s income statement does not mean that valuation doesn’t matter. On the contrary, the takeaway should be that investors must learn to interpret such metrics on a deeper level. Spotify was trading at around 1.3X sales when I made my big purchase back in January 2023. When you have a company with extraordinary organizational properties (and thus a high likelihood of exponentiating free cash flow per share) together with a valuation below 4X sales, that stock is in the fortune-making zone.
The classic text What Works on Wall Street may seem ancient and in diametric opposition to the idea of newfangled valuation techniques, but in reality it’s quite the opposite: one of the book’s central theses is that stocks are best valued not through P/E but P/S. Every ounce of what’s taught in my Tech Stock Goldmine course remains steeped in the axiomatic truth shared by greats such as Warren Buffett and Phil Fisher that stocks follow FCF/share.
Together with Amazon, Spotify is a prime example of how, in the network-defined economy, scale and network effects precede profits. Spotify has focused on compounding scale and customer goodwill for decades, only to focus on making money nearly two decades down the line–a pattern we see playing out with Palantir as I type these words. As previously mentioned, this sort of strategy will become more prevalent. The best investment you can make at this point is to learn how to spot successful instances of extraordinary organisations before the momentum mob arrives.
In the previous few paragraphs you will notice that, although the P/E is not quite as useful as it once was, quantitatives are still the signal that prove out your qualitative observations. If you want to radically improve your ability to pick winners by merging quantitative and qualitative signals, consider taking my Tech Stock Goldmine course.
The course sells for just $300 and has been tried and tested by hundreds of happy students to date.
Until next time!
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